The Social Market Economy [Part 1 of 2]
Robert Skidelsky
Social Market Foundation Paper no. 1 [1989] | Sunday, January 01, 1989

 1 INTRODUCTION
 
The most hopeful political development of recent years is revival of belief in the market system. It has become worldwide, uniting rich and poor, capitalist and socialist countries in a common language and the beginnings of a common practice. In Russia, China, and Eastern Europe, the monoliths of state socialism have started to crumble; in the West the army of officials is in retreat. New Vistas of freedom and peace have opened up as the world starts to converge on the ideals of political and economic liberty.
 
This global turnabout has already had an immense effect on the thinking of the Left. But there is a world of difference between "coming to terms with" market mechanisms or accepting their use where "appropriate", and commitment to market economy as a social institution. The use of the phrase "social market economy" signifies a choice in favour of market economy. It means that we turn to the market as a first resort and the government as a last resort, not the other way round. It means that our first instinct is to use the market, not to override it; and that we are not afraid to apply the logic of this to matters of thought, expression and behaviour, which most governments, not least Mrs Thatcher's, have an incurable urge to control.
 
Having said this, there remains a substantial role for government. Adding the word "social" to "market economy" is not just a political flourish. Its object is to draw attention to the elements of statesmanship and design necessary to sustain a market order. Market exchange may have developed spontaneously. But the market system is not a culmination of spontaneous social evolution, as Hayek believes. Despite its powerful intellectual supports, and practical achievements, it remains a fragile institution, not much loved; the Utopia of some intellectuals, but the villain of others; feared by most producers, taken for granted by most consumers. At all stages its relationship with the state has been crucial for its development. The state has encouraged it, but also shackled and distorted it; has protected it, and protected people from it.
 
Those who value the market as an institution must be concerned to keep its support system in good repair. The state's role is essentially threefold: (a) to create and maintain an appropriate legal framework for market exchange; (b) to limit and supplement the market where necessary; and (c) to ensure that the market is politically acceptable. A social market economy is, above all, one which is embedded in social arrangements regarded as "fair". These matters will form the main topic of this essay. But before developing the argument, a historical retrospect is in order.
 
2 RETREAT AND REVIVAL OF THE MARKET
 
History never repeats itself. But there may be long cycles in attitudes towards states and markets. In 1922, the economist Hubert Henderson wrote:
 
When a century and a half ago, the foundations were being laid ... of systematic economic theory, the public attention was much occupied ... with the failings of Governments. The keynote of the economists' conclusions was that Governments were doing immense mischief by meddling with a great many matters, which they would have done better to leave alone ... Let Governments preserve law and order; and leave the economic sphere alone... An ideal of perfect competition became an idol to which much human flesh and blood were sacrificed.1
 
By the 1870s the pendulum had started to swing the other way, and the "age of collectivism" had begun. Existing economic arrangements were castigated for failing (a) to shift the poverty of a large minority of the population; (b) to protect or compensate the victims of change; (c) to provide regularity of employment; (d) to protect domestic industries against "unfair" foreign competition; (e) to prevent the rise of monopoly power; (f) to provide adequate standards of education and health care.
 
Collectivism came in both mild and virulent forms. Social reformers - the advanced liberals and social democrats of that time - wanted to redistribute wealth and income, provide compulsory insurance against unemployment, sickness, and old age, and extend public provision. They started the Welfare State before the first world war. Although they understood the need to make the economy more "social", they had little specific appreciation of the market as a social institution. For socialists, Adam Smith's "invisible hand" was a recipe for anarchy and the exploitation of workers by capitalists. Their remedy for both (at least in the Fabian version) was public ownership of the instruments of production, which was itself seen as redistributory, and making for production according to need rather than profit. By redefining freedom as power ("positive" freedom), collectivists of both persuasions were able to claim, contrary to historical experience, that freedom was expanded by increasing rather than reducing state power. We will return to this confusion in Section Five.
 
The potency which these collectivist criticisms acquired can be explained by a number of background factors. The most obvious was the growth of democracy which brought the "social question" into the centre of politics. For the first time in history, a majority of the electors consisted of the propertyless, with party competition geared to winning their support. The second factor was the rise of the social sciences. The promise here was that "collective" knowledge and intelligence could be brought to bear on social and economic problems, the contrast being with the "anarchy" of the market. A third factor was a growing confidence in government. Governments, it was assumed, could be relied upon to act more wisely than in Adam Smith's day. The civil service had greatly improved in knowledge, capacity, and integrity. Governments were more accountable to the people, less to "vested interests", than they had been in the 18th century. Fourth, there was the growth of social conscience of the better-off. Whereas previously the misfortunes of the poor tended to be blamed on their character defects (eg., drink caused poverty), now they tended to be blamed on a bad environment (poverty causes drink). Improvements in social arrangements - particularly in education and health-care - were the key to improved characters and, hence, life-chances. This fitted the mood of late Victorian evangelicalism. Fifth, there was the problem of unemployment, widely identified as the most costly example of "market failure". Mass unemployment was often linked to a sixth factor – the replacement of competition by private monopoly in many sectors, which seemed to open a wide field for government regulation, or even public ownership. The era of producer- group politics seemed to have arrived, giving government a much greater role as guardian of the "public interest". Finally, we must not underestimate the importance of the two world wars and the attraction of the war model to many on both right and left: a unity of purpose underwritten by high rates of taxes, "fair shares", authoritative allocation of resources dictated by social needs, and promises of a better life for the poor. If the
government could commandeer resources for producing munitions, why not houses, hospitals, schools?
 
Twentieth century collectivism established itself in a variety of forms, ranging from the totalitarian, centrally-planned economies of Soviet Russia and Nazi Germany, to the milder forms favoured by the democracies. The common features of democratic collectivism were: (a) the public ownership of "basic industries" (mainly, but not exclusively, public utilities); (b) a great extension of non-market (government) provision of services like education, health, and housing; (c) an indifference to competition, exemplified by high levels of protection and encouragement of concentration of production in large units and centralised wage bargaining as facilitating "planning" of production and incomes; (d) a severe curtailment of international capital markets; (e) the use (particularly in Britain) of discretionary fiscal policy to "balance" the economy at full employment.
 
The overall effect of these measures was to limit the scope of "market economy" and to regulate it more tightly and "correct" its malfunctions more actively. Indeed, the phrase "market economy" dropped out of use. The political debate was between defenders of "free" or "private" enterprise and "the profit motive" and those who wanted more public ownership and more planning. There was some liberalisation in the 1950s, when governments of the right were generally in power, but the collectivist mindset remained in place, and was strengthened in the 1960s when planning for growth and incomes policy were added to the collectivist repertoire. The strongest reaction against democratic collectivism came from those who had experienced, or were connected by background with its totalitarian forms. Friedrich Hayek's The Road to Serfdom was published in 1944 and followed by his more profound Constitution of Liberty in I960. More important in the present context was the German concept of the "social market economy" which was born in the rubble of the Third Reich. This marked an explicit revival of the market philosophy; but also an understanding of the need to create secure social foundations for market exchange.
 
The social market economy was seen as a means of dispersing economic and political power. Ludwig Erhard, one of its architects, who later presided over Germany's "economic miracle", attributed the collapse of the Weimar Republic not just to political events, but to its "impossible economic system, which was a fateful mixture of socialism, cartellization, and old-fashioned capitalism". 2 What was distinctive about the German conception was the close attention given to its legal and social foundations; "deproletarianisation" was as important as decentralisation. The social market was adopted as an organising principle by the CDU (Christian Democrats) in 1949, and was subsequently endorsed by the SPD (Social Democrats) in 1959.
The main features of the German model were as follows:
Competition. One way the social market theorists aimed to keep the market social was by eliminating all aspects of monopoly. According to Franz Bohm: "Competition is the greatest and most congenial way of reducing power in history. You only need to invoke it and it does the rest of the work by itself."3 For Wilhelm Ropke, the social market represented a choice "in favour of the small and medium-sized firm". Erhard laid chief stress on the need for international competition. Only under competitive conditions would prices be determined by the market.4
 
A sound currency. This was always a crucial background condition: "... a pre-condition for successful wealth formation is a relatively strict policy of financial stability."5 The German Bundesbank has a legal obligation to safeguard the value of the currency.
Equality of Opportunity. According to Von Rustow, the only justifiable inequalities were those which arose from inequalities of accomplishment or the conditions of competition. "Most unjust of all are those inequalities in the conditions existing at the start of economic life, derived in part from unequal inheritance, which depend on how carefully one chooses one's parents. This being the case, we are led to demand ... just initial conditions for all." 6
Co-determination. A leading aim of the Dusseldorf Principles of the CDU (1949) was to involve “representatives of the workforce at factory level and in national supervision of economic life in order to achieve the essential trust of all strata".
 
These principles determined a role for the state. Its main economic functions were to sustain competitive conditions; promote a more equal distribution of assets and skills, together with a system of industrial power-sharing; and maintain sound money.
The German model had the great advantage of concentrating attention on the legal, social, and technical conditions required to make a market economy work well. Such clarity was never achieved in Britain, where old-fashioned capitalism, socialism, the Welfare State, and Keynesian macro-economics were wrapped in an ill- assorted package labelled the "mixed economy". The consensus which sustained this mixture proved to be highly vulnerable, because it concealed a basic ambivalence about the justification of markets, and indeed about the private enterprise system itself.
 
The German model is thus a useful reference point, but it should not be accepted uncritically. First, it assumed that the only important cause of market malfunction was lack of competition, and thus ignored other causes of malfunction which might have important implications for policy (these are discussed in Section Four). Second, "co-determination", designed to win workers' consent to market forces, can easily become a force for resisting them. The lustre of the German system started to fade in the 1980s as dynamism gave way to stagnation.
 
The German model had little influence in Britain until the 1970s, when the failures of our own mixed economy became too gross to ignore. I have suggested elsewhere7 that it was the attempt to plan both growth and incomes in the context of a divided politics and an adversarial system of industrial relations which brought Britain to its knees in the 1970s. The important point is that neither of the two main political parties believed in the market economy by 1975. The Labour Party's revisionism of the 1950s has been much misunderstood. Anthony Crosland in The Future of Socialism (1956) accepted capitalism precisely because, in his view, it was no longer tied to market competition: his model of the economy was corporatist, not competitive. Edward Heath was, at heart, and increasingly in practice as Prime Minister, a corporatist. His outlook was that of a manager of big blocs of business and union power. Revival of interest in the market as a social mechanism dates from the early 1970s. It owed a great deal to the powerful advocacy of economists like Hayek, Friedman, and Samuel Brittan, and think-tanks like the Institute of Economic Affairs. The left contributed little to this revival until the SDP was founded in 1981.
 
To succeed, ideas need the help of circumstances. Four circumstances contributed to a revived belief in the market.
 
• There was the progressive failure of Keynesian macro-economics to secure the internal and external balance of the economy. The trade-offs between inflation, unemployment, and a healthy balance of payments all worsened in the 1970s. It was taking more and more inflation to achieve a high level of employment; and more and more unemployment to prevent inflation from rising and the external value of the pound from falling. Although the problem, arguably, lay in the inflationary management of the macro-economy, the only solution the Keynesians had was "incomes policy" which aimed at controlling costs. What such policy achieved was a great increase in union power without, except for short periods, bringing the promised relief in the form of lower wage demands. By the end of the 1970s there was no credible alternative but to stop inflationary government finance and to allow unemployment to rise to whatever levels necessary to bring prices under control. This painful process revealed, for the first time, the true decline in British competitiveness: the extent of the misallocation of resources, mismatch between jobs and skills, and disincentives to save, invest, and work which had built up in the "Keynesian" years; in brief, the extent to which Britain had ceased to function as a "market economy".
 
• The second factor was the growing power of the unions, and the public revulsion against it. By the end of the 1970s employers, workers, and governments could do almost nothing without the
permission of the trade union bosses, themselves often subject to the pressure of militant minorities. Trade union power rested on a simple absence of legal restraint on any of the unions' coercive activities, it being hallowed doctrine that the law had no part to play in industrial relations. Britain suffered heavily from inattention to the legal foundations of a market order.
 
• Thirdly, the 1970s brought an increasing public and intellectual appreciation of the problem of "government failure". In the heyday of collectivism all the attention was focussed on "market failure". Little thought was given to the question of how well governments could perform the tasks markets were failing to do, or were doing badly; and it was assumed, without too much question, that some sacrifice of freedom was a small price to pay for the social and economic advantages which governments might directly bring about. But gradually the evidence of government failure mounted up. Keynesian policy stopped working. The taxation system, geared to social and economic objectives, lost any contact with concepts of simplicity, equity, or neutrality and became a field of plunder for vested interests, and armies of lawyers and accountants. Public services seemed to exist more to serve those who worked in them than their customers. Governments seemed to be getting bigger and costlier and more incompetent and ineffective at the same time. A powerful reaction to all this was "less government and more market".
 
• The recent era of turbulent technology, heralded by the microchip/computer revolution has been market-friendly in a way the older technologies were not. What seems to have happened is that the new technologies, combined with the recession of the early 1980s, have removed "barriers to entry" in a number of occupations by reducing the advantages of "economies of scale". The newspaper industry is a notable example: the new computer-operated photo-composition methods should reduce the relative advantage of large circulation papers, making possible a proliferation of new titles. Another notable effect of the new technology has been felt in financial markets. Data, especially for this country, are very hard to obtain, but the idea that we are moving from a "Fordist" or mass production/mass consumption era into one in which smaller firms will cater to increasingly segmented markets appears to have some substance. Not only have large firms been decentralising their operations and dispersing their plant so that most workers now work in units of under 200 employees, but there has been a striking growth in the number of small manufacturing and service establishments, together with an increase of over one million in the number of self-employed persons between 1979 and 1988. The British economy is becoming more miniaturised, spacially dispersed, and organisationally decentralised; on the other hand, the very largest companies seem to be getting bigger, because more international. Much more research is needed into this whole question. What is apparent is that the old pluralist and corporatist view, which took for granted the need for bargained relationships between large blocs of economic power, may need to be drastically revised.
 
Thus the movement of ideas in favour of a more decentralised, competitive and entrepreneurial economy seems to have behind it not just the failures of the old system but the force of the new technology. The concept of the "social market economy" is a positive way of responding to these challenges. It recognises the instrumental efficiency of decentralised decision-making, as well as its connection with freedom, while setting market processes in a social democratic value system.
 
3 THE MARKET AS A SOCIAL GOOD
 
The most important shift in political economy between the first and second halves of the 20th century has been the move from indifference or hostility to the market to explicit recognition of the market as a social good. This shift has now become world-wide. It runs all the way from Thatcher to Gorbachev. It has affected rich and poor countries alike; it has transformed the disciplines of economics and economic history; about how we think and act about the problems of the poor, whether these be poor countries, or poor groups within rich countries. It marks an intellectual and political watershed. That is why the older languages of the Left which concentrated exclusively on collective goods and collective action are no longer appropriate.
 
The case for the market rests positively on its contributions to freedom, efficiency, and dynamism and, negatively, on the inferiority of planned systems in all these respects.
 
The most powerful argument for the market economy is that it decentralises decision making and makes possible the uncoerced co-operation of people for their mutual benefit. It achieves this not by relying on altruism, which is in short supply, but by making the pursuit of individual plans the means for satisfying the plans of others. It was Adam Smith who first fully saw in the mechanism of market exchange the basis of a spontaneous social order. The individual is "led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it."8 The conditions for free exchange in markets are the same as, though less extensive than, the conditions of freedom generally: freedom of movement and choice of job; freedom of contract; properly defined and enforced property rights. The market system thus provides a powerful protection for political and civil liberty, because it minimises concentrated political power and disperses power in general. Furthermore, the market system provides a wider basis for co-operation than the political system, because it transcends national frontiers. It is thus an international system of liberty. In addition, the impersonal nature of its interpersonal relationships makes it both colour and gender blind: it is the best safeguard in the long run against racial and sexual discrimination.
 
If these conditions are maintained, the market can also be shown to be efficient in coordinating individual plans. Under very strong assumptions (perfect competition, perfect information, perfect rationality, etc.) it can be shown to be perfectly efficient at doing this. A state of perfect efficiency is said to exist if everyone's choices, given his resources, are perfectly satisfied by the existing allocation of goods and services. The conditions for perfect allocation are, of course, never realised so it is a matter of relative efficiency of want satisfaction compared to other systems. It is important to note that the market does not guarantee that everyone is perfectly, or even moderately, satisfied with the resources he "brings to market". It is the task of the "social" side of the market to address this problem.
Hayek and Schumpeter have enabled us to appreciate anew the creative role of markets - creating new wealth, new tastes, new possibilities or living. This is the function of the entrepreneur, the creator of the unforeseen and unpredictable. "It is because every individual knows so little and, in particular, because we rarely know which of us knows best that we trust the independent and competitive efforts of many to induce the emergence of what we shall want when we see it."9
 
The fact that every planned system necessarily violates some condition of freedom, efficiency, and creativity is well understood now, and need not be elaborated further. Less well understood is the connection between the three goods of a market economy and the right to private property in the means of production (capitalism). The recognition of what Hayek calls "private or several" property automatically limits state, and disperses private, power.10 Efficiency in allocating resources requires that the factors of production Gand, capital, and labour) are allowed to move to their most valued uses. How, for example, is the state to calculate the optimal rate of saving and investment - one that accurately reflects individuals' time preferences and the uses to which they wish to put their saved
resources? Finally, the chance to gain wealth is a strong incentive to risk-taking and innovation. No comparable bureaucratic motives for risk-taking have been discovered.
 
To say that the market is efficient in satisfying wants is to say that it is an accountability mechanism. The way the market is accountable to the consumer is through the right of "exit". If consumers are not satisfied with one supplier they can switch to another. This requires a number of firms which compete with each other for the consumer's custom. The main accountability condition is that no single seller controls the price or quantity of a product. A firm's ability to enter a trade is therefore essential to maintain the customer's right of exit. To maintain not just the right of entry, but conditions in which entry is not too costly, is thus the object of competition policy.
 
Genuine though the difficulties are in maintaining competitive conditions, there is no equivalent accountability mechanism for statutory monopolies, or public services which the majority of people are constrained to use through lack of resources. It is clear that financial accountability of such services to governments and local authorities ("value for public money") is not the same as accountability to the customer. The Left has tried to develop an accountability model based on "voice". This is, more familiarly, a voting or participation model. Voters decide between different allocations of public money (taxes). Channels or institutions are created for users of public services to make suggestions for improving delivery, or to take part in forming policy.
 
The trouble is that it is extremely difficult to secure adequate accountability once the direct nexus between contribution (payment) and benefit (good) is broken. Voting notoriously fails to achieve outcomes which are clearly related to individual preferences. Nor do other "voice" models help much. Monopoly providers of services are notoriously insensitive to customer complaint or interference. And most public services are run by professionals who "know best". The Left's traditional answer has been to abolish the right of exit, for example, the right to private education or health-care, in order to lock the articulate into public systems. Not only is this an infringement of liberty, but the assumption that the articulate are representative of the majority is quite unfounded; they are more likely to form a special interest of their own. Latterly, more emphasis has been placed on decentralisation of delivery down to Burke's "small platoons" beloved of David Marquand. But such small platoons can be more oppressive than large battalions, as the medieval charivari demonstrate. A plausible story of accountability through "voice" has yet to be told.
 
This makes it all the more important not just to maintain rights of exit from all public services, but to create as far as possible "internal markets" within them. David Owen has advocated giving a patient the right to be referred for treatment to another District Health Authority's hospital, or even privately, when the waiting time for a particular type of treatment exceeded a certain period, his own DHA paying the cost in both cases.11 The Conservative government has given parents a limited right of choice of school. Beyond this, Arthur Seldon has advocated charging for separable benefits in publicly provided goods like health-care and education, with consumer-patients or consumer-parents "empowered" by being issued with vouchers of lower or higher value (depending on means) to be spent on doctors, hospitals, and schools of their choice.12 Ultimately, it is the feebleness of accountability under conditions of "social choice" which constitutes the chief argument for relying on "market choice".